Use ETFs to manage risk

Kirk Spano, the winner of the first MarketWatch competition
to find the world’s next great investing columnist, is a registered investment
advisor and founder of Bluemound
Asset Management, LLC which seeks to provide investors with greater safety,
growth, income and freedom. Kirk’s biography and various business endeavors can
be found at KirkSpano.com. Follow Kirk on
Twitter @KirkSpano or at the
Bluemound Facebook page for his columns, company analysis, letters, trade
notes and what he is reading.

In my last column I talked about how mutual funds generally can't protect your portfolio from large losses. Today, I'll discuss how using exchange traded funds — ETFs — can be an excellent tool for managing risk in down markets, as well as, a way for you to participate in up markets.

This week was the Index Universe ETF conference in Florida. While I wasn't lucky enough to leave the oppressive Wisconsin winter, I do know a few folks who went, and we've now talked. One of the clear observations they made was that ETFs are fast becoming the vehicle of choice for investment advisers who manage money, and especially institutional investors. This should be a gigantic clue to retail investors on the direction they should take.

For those who aren't completely familiar with ETFs, I'm going to start with a description from the Wall Street Journal:

"Exchange-traded funds, commonly called ETFs, are index funds that trade like stocks. As such, they have all of the benefits of plain old index funds with some added punch. The fees for ETFs are often — but not always — cheaper than index funds, and they may cost you less in taxes."

For many investors, the temptation with ETFs is to find a better way to chase return on the upside. While that is sexy, the core benefit of using ETFs, in my opinion, is how well they lend themselves to risk management. The ability to sell ETFs when the going gets rough is something that mutual funds don't offer in as timely or cheaply a manner.

A couple of weeks ago, I let readers know that we had lightened up on the SPDR S&P 500 ETFSPY, -0.15%
and sold outright the iShares Select Dividend ETFDVY, -0.03%
This move brought our cash allocation up significantly — to about 50% — ahead of the mini-correction.

For us, the sells were not predictive of what the market was going to do next, rather the moves were tactical based upon reading trends. Mathematical indicators told us that risk was high and potential return was low, so we sold our most at-risk holdings. There was no crystal ball, we were simply able to evacuate the market faster than other people — particularly mutual-fund investors — and avoid a good deal of the losses. This is a tactical method of using ETFs.

The reason I use ETFs this way is that most investors are more risk averse than they might claim. While folks want relative return on the upside (they want to keep up with a rising market), they also want absolute return on the downside (they want to miss the downside). Clearly mutual funds don't offer much chance for that scenario to play out.

With ETFs, we can adjust our asset allocation in a knowable way based upon market risks much faster than mutual funds, which allows us to miss more of the downside and catch about as much of the upside. That is a winning equation.

On Monday, as markets stabilized, we allocated some money to the iShares Core S&P "Small-cap ETFIJR, +0.50%
to bring us back to an equity-heavy asset allocation. Once again, the trades were not predictive, but reactive. By the time you read this, if markets weaken again, possibly due to the increased tapering, weak earnings, international issues or something else, we might be out of some or all of our equity holdings.

This sort of trading has been unusual for us the past couple of years, as we have been able to sit back and ride the steady drift upward which I first told people was beginning in January 2012. Looking back at 2011, which was more volatile, but ultimately a flat year, we had to trade more in order to mitigate risk. So far, 2014 is shaping up to require as much trading activity as 2011.

There's a lesson consider — which is found in the common phrase "the trend is your friend." When there are strong rising market trends, there is little to do but monitor risk and take the ride up. When trends become weak or break down completely, though, depending on how much risk tolerance you have — based upon things like income needs, investment time horizon and how well you sleep in a volatile market — it is time to take defensive action, that is, sell some riskier holdings in order to increase safety.

I have talked about tactically trading ETFs a few times now, including on June 21 and Dec. 19. In our tactical asset allocation portfolios — different than our discretionary stock and option portfolios which are meant for more aggressive money — we are trend followers with a bias toward risk management over maximizing upside returns. Algebraically, this works for us over the long haul, since we avoid big negative numbers in the performance column.

For most people's retirement nest-egg money, a tactical asset-allocation approach using ETFs is a winner by both adding some safety from big declines and maintaining competitive long-term returns. This is what the big money managers at the institutions are thinking too.

Kirk Spano and clients of Bluemound do own shares of SPY and IJR. Opinions and holdings subject to change at any time.

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